The Joy of Debt

Financing your company is getting more complicated all the time. There are lots of new ways to snare debt and equity capital. That's nice. But all the choices have made it easy to lose sight of one of the most fundamental questions that you have to ask yourself: how much debt should my company have? Answering this question has always been important. But now that the economy shows signs of weakening, it's critical. Recessions historically mean trouble -- even death -- for overleveraged companies.

Everyone knows that at least some debt is desirable. After all, a profitable company with debt will earn far more than it would without it. That's what leverage is all about. What's more, thanks to the tax code, debt is nearly always cheaper than equity.

But how much is too much? This is the tough question these days, because being in hock has never been more popular. Once-stingy commercial and investment bankers are happily endorsing debt-to-equity ratios of 10:1 in leveraged buyouts. Academics have developed new philosophies to justify those extraordinary debt levels. So thoroughly has the New Theory of Leverage swept the country that "the balance sheet of a newly leveraged corporation often resembles a bankrupt's," observes James Grant, editor of Grant's Interest Rate Observer.

Of course, for some companies the debt question is academic -- they don't have the luxury of choice. They're brand-new, so they'll take whatever debt they can get. Or their bankers keep them on a short leash; for them, the massive debt levels of leveraged buyouts such as RJR Nabisco are about as accessible as its market share.

But for other companies, the new debt theory is worth a close look. You probably won't want to adopt hyperleverage, but you may want to use its principles in thinking about your company's debt levels.

The key difference between the old and new standards involves how you measure a company's debt capacity. For a long time, bankers and investment bankers thought debt levels should be determined by the amount of equity on the balance sheet. They prescribed a ratio of debt-to-equity that was prudent for every industry. To come up with that ratio, they considered an industry's cyclicity and capital intensity, as well as other factors. As a company, you were pretty much obliged to live within your industry's standards, even if your business didn't act like everyone else's. Thus, if you were in the business of selling Yuppie Yippers gourmet dog biscuits, you would have been expected to hew to dog-food industry standards with a debt-to-equity ratio of, say, 1.5:1.

Eventually, people began to see that this didn't make much sense. They began to appreciate the difference between Yuppie Yippers Inc., for example, and Basic Bones Co. The first company charges a steep 10¢ per biscuit and sells them through its own national chain of Dairy Queen-style stores. The second company sells its dog-bone biscuits for about half as much and distributes them through grocery stores. Bone for bone, Yippers has higher costs than Basic, but it has higher revenues, too. So let's say that their profit margins are about the same.

Under the old standards, both companies would have to adhere to the same 1.5:1 debt-to-equity ratio. The trouble is, profit margins are based on earnings. And earnings are an accounting fiction, not a barometer of how much cash a business generates.

For example, Yippers buys its biscuits from a wholesaler, whereas Basic makes its own in a relatively new plant. That means that Basic shows depreciation as an expense on its income statement, but Yippers does not. Depreciation isn't a "real" charge because it doesn't use cash, so Basic's cash flow is higher than its earnings would indicate. Yippers's is not. Also, Yippers rents its stores, so it has high fixed expenses that eat up cash flow. In contrast, Basic has no such drain on its cash.

Of course, many other elements go into calculating cash flow, but the point is that despite its prosaic product, Basic throws off much more cash than Yippers. And cash is what pays interest and principal. In fact, the more industry analysts and bankers have thought about it, the more ridiculous industry standards have begun to seem. In terms of cash flow, Yippers probably resembles Häagen-Dazs more than it does Basic. Eureka, financiers exclaimed -- maybe cash flow should be the chief measure of how much debt a company can shoulder.

Now this isn't an entirely new notion. Bankers have always looked at cash-flow predictions to figure out if their borrowers will be able to repay a loan. What's so different is cash flow's primacy. It's not just a matter of how much cash a company generates, it's how dependable that flow is. Basic could probably handle many times as much debt as Yippers not only because its cash flow is greater but because its cash will be there year in and year out. Yippers hawks a luxury biscuit -- the first thing dog owners are likely to do without when times are tough.

It's easy enough to get carried away with this idea. As long as your cash flow runs deep, why not leverage your company 10:1, like the LBOs? The reason: because debt doesn't work its magic all by itself. You have to be able to use the borrowed money in your business to create returns that are greater than the aftertax cost of your debt. Let's say that Basic Bones can borrow at 12%. If its tax rate is 34%, then the aftertax cost of its debt is about 8%. To make leverage work in its favor, then, Basic must plow the borrowed cash into making and selling more biscuits that will earn an aftertax return greater than 8%. If it can't, Basic will see debt's ugly side in sagging profit margins.

Cash is definitely king in the new debt theory, but there are other elements, too. Instead of focusing on what will feed debt, they center on what will keep debt from turning nasty. One technique is simply to match debt perfectly to cash flow. To do this well, you need to have a crystal-ball vision of the future: when you'll build another plant, when you'll sell any major asset, when the next downturn will put a dent in your cash flow. Once the future is laid out in cash-flow projections, arranging debt with the appropriate terms and maturity is the next step.

Precision-debt design is almost as important as its cost. Think about the average life of your debt. Do you have the full use of the borrowed money for five years, or partial use? Will you have to make a large principal repayment just when expenses are running high because you open a new office in Honolulu?

Financial technology is the other key component to keeping large debt levels under control. During the past decade, financial institutions have created a wide array of devices to help borrowers protect themselves from soaring interest rates. Known as swaps, hedges, and collars, these techniques tame floating-rate debt by turning it into a fixed-rate loan, or by keeping the interest rate caged within narrow parameters. You have to buy this peace of mind, though. Unless you've got a good-sized chunk of debt -- say, $5 million or $10 million -- such insurance may not be worth it.

But real peace of mind can come only from you. With a recession possibly lying in wait, the most practical use for the fashionable new debt theories is to adopt what makes sense for your business and ignore the rest. After all, being in vogue won't pay back the borrowed money -- you'll have to.

THE MORE THE MERRIER

How companies justify carrying higher levels of debt

If a little is good, more is better. At first glance, that appears to sum up the current debt craze. But there are philosophies behind the extraordinary debt loads of leveraged buyouts. Philosophies, of course, can be wrong, and these very well may prove to be failures when the next recession hits. But, as with most innovations, there's probably something to be learned as well:

* Cash flow, immutable cash flow. You can afford as much debt as you can service with the cash that your business throws off. The size of your equity doesn't really matter. Just be sure that cash flow is bedrock solid and won't disappear in the next downturn.

* Debt lifestyle. All debt is not created equal. Tailor every detail of your loans' terms to fit your future cash flows and cash needs.

* Collars and muzzles. Once upon a time borrowers could do nothing but cower before a floating-rate loan when interest rates rose. Now, there are swaps, hedges, and collars, all designed to make those loans behave, even if interest rates spike.